Wednesday, January 1, 2020

QE4, Repo, Inflation, Debt: A decade of monetary stimulus and the consequences of more

It’s been over 6 years since I’ve written anything on the Federal Reserve (Fed) and the economy. Truth be told, in mid-2013 with the Fed Funds Rate (FFR) pegged at essentially zero, real interest rates quite negative, and global debt ever increasing, I threw up my hands and gave up trying to convince people that we had a problem. It didn’t help that the stock markets propelled forward year after year, supported and backstopped by the Fed’s monetary easing policies, without an end in sight. 

Then came the Fed Funds Rate increases, starting in December 2015, after a 7-year peg at a record low of 0-0.25%. Only a 25-basis point increase, until a long year later in December 2016 when the rate was increased again by 25bp, to 0.50-0.75%. In 2017, the Fed increased rates thrice, in March, June and December by a collective 75bp. In 2018, the Fed continued to increase rates four times, in March, June, September and December by a collective 100bp increase, until the markets had a collective fit at being starved of monetary easing, with the Fed commensurately reducing its balance sheet from some $4.5T at the end of 2017 (pegged at $4.5T high for 3 straight years) to $3.77T interim low on September 9, 2019. 

Then came a Repo Market intervention by the Fed on September 16, 2019, the first in some 7 years since the failure of MF Global, a response to a spike in repo rates to ~10% that sent a shock wave through this short-term funding market, now linked to money markets and cash liquidity. For those looking for definitions of the Repo market and its history in the tumultuous years of the last financial crisis and after, please refer to my previous well-researched article “Repo Markets and Financial Instability” [1]. Below I have included updates to the size of the Repo markets as they have progressed over the last decade, and the Repo Rate and Fed Funds Rate compiled from FRED








So why did this spike in repo rates occur, prompting a Fed response that looks an awful lot like more monetary easing (call it QE4)? For those questioning whether this response is monetary easing or something limited to quell the repo markets and a short-term cash crunch, refer to the chart below showing the Fed balance sheet, which shows a reverse course of balance reduction to balance increases. Some have argued that the increases in the Fed Funds Rate and the reduction of the balance sheet put undue pressure on the markets, indicating that the Fed has to remain an active and continual participant (buyer), not a “lender of last resort”. Indeed, if the Fed continues to ease, by increasing its balance sheet (buying Treasury, Mortgage-Backed Securities (MBS) and other debt) it will leave little room for a real response should much greater shocks occur, such as Treasury or other market interest rate spikes, an indication that there is selling pressure or a serious lack of market buyers for debt, particularly as the debt issuances increase, and they only will increase. 





Critics of this scenario, and supporters of what the Fed does and can do, will just say that the Fed can “invent money” to buy up debt until the markets calm. They will continue to say that inflation is too low, and that rates can continue to come down and the balance sheet can continue to grow until inflation hits the target of 2% or greater. In fact, the Fed recently revised this target to 4%, stating that it miscalculated the inflation response when unemployment rates hit what the Fed thought was a level requiring a 2% target inflation response: that level was 5% around January 2016 and then 4% around March 2018. The unemployment rate now stands at 3.5% and the Fed tells us that the inflation target of 2% still hasn’t been met – refer to the comparison chart below that I compiled from FRED, including what the Fed reportedly [2] uses as its measure for target inflation, the chain weighted Personal Consumption Expenditures (PCE) against the broad Employment Cost Index and the U3 Unemployment Rate. I also include the Fed Funds Rate for comparison.








I have continually asked how far this “strategy” can go until it doesn’t work anymore. Eventually it will weaken the dollar and inflation will increase. How sharply might that happen? By the time those sharp increases are realized, we may have been boiling for some time and reverse courses might require increasing the Fed Funds Rate substantially. Most worrisome is that the Fed will lose control of manipulating the Treasury curve in both level and steepness, the amount of tool wielding becoming impotent. 

We should all be asking three questions here: (1) What is the real inflation and what does the Fed measure and report to gauge their target responses? (2) What is the real unemployment and what does the Fed measure and report to gauge their target responses? (3) Are the reported statistics (inflation, unemployment, interest rates, GDP, dollar index, debt levels) becoming more correlated or more uncorrelated?

I submit that the real wage inflation is lower, and core CPI inflation and actual unemployment much higher than the reported numbers used by Fed policy makers, which I have already reprinted here from FRED compilations (above graphs). I also submit that the reported statistics have decoupled somewhat from each other, to the point that has allowed the Fed cover for applying whatever policy response they want, nominally to control the Treasury curve and the Fed Funds Rate. In fact, the Fed has already admitted this by stating that the expected wage inflation and core PCE have not correlated to the U3 unemployment numbers, as they expected [3]. 

What are the real numbers and why doesn’t the government report them, or the Fed track them? I discuss alternate statistics for inflation, unemployment, GDP and the USD Index in the previous article, “Inflation, Unemployment, GDP and USD Index Statistics: What can we really believe?”. In summary, alternate measures for inflation are running around 5.7% vs. the Fed’s core PCE measure of 1.6% and the official CPI measure of 2%. Basically, wage inflation has been far outpaced by real inflation for costs of living. Alternate measures for unemployment are around 21.5% vs. 3.5% for U3 unemployment and 7.5% for U6 unemployment. Alternate GDP is around -2% (contraction since 2004) vs. 2% reported by the BEA and tracked by the Fed. Alternate financial weighted USD Index is around 60 vs. the reported FRB trade weighted dollar of 67 (indexed to January 1995). 

What is reported as real and growing at more than a 5% annual rate is the national debt, which can be measured as a %GDP. This is shown in the following compilation from FRED, data sourced from the Treasury and BEA. The national debt level at almost $23T is 106% of the overstated GDP, and much higher for the alternate GDP. The U.S. has over $42T (33%) of the total global marketable debt outstanding, which includes not only the national debt financed by Treasuries but also all other types of debt, such as Mortgage and Asset Backed Securities (MBS, ABS), Corporate debt, Muni debt, Consumer debt, etc. This is more than triple the next highest debtor nation, now China. 





Given the amount of understated inflation and unemployment, and the amount of overstated GDP and USD Index, the Fed’s policy of continued easing in the face of increasing debt may make more sense, but it does not fix the serious structural problems that we still have with high debt growth, real unemployment, sagging productivity and industrial production, and a continuing negative balance of trade. All of these issues are fiscal and business macro in nature, and the Fed chooses to plaster over these problems with continued easing to stave off real interest rate risk. As I mentioned at the beginning of this article, I have been waving this flag for a decade, but the proverbial can just keeps getting kicked. If you missed out on the market growth of the last decade, asset price inflation or Ponzi Finance, it was a spectacular miss. Regardless, perpetual motion machines don’t exist, and therefore all of these structural problems will manifest themselves in a much more obvious way (recession or worse), with the Fed finding it much tougher to use its policy tools to fight the consequences. 

As a comparison to the situation over two decades ago when the debt levels were much lower, the reported unemployment and core inflation around the same levels, productivity and industrial production much higher and a much lesser negative balance of trade, the Greenspan Fed chose to raise the Fed Funds Rate from around 4.5%. [Specifically, for January 1999: National Debt $5.6T (60.4%GDP), U3 Unemployment 4.3%, Core PCE 1.3%, Productivity and Industrial Production in excess of 4% (now 1% and negative), Current Balance -$60.8B (presently -$124B).]

I’ve primarily written about the hazards of cheap money and monetary easing, here and elsewhere. Admittedly, it is hard to convince many of the hazards when the markets (stock and bond) have a record decade, as they have had from 2010-2019. Markets love monetary easing (chart below). The hazards: risk asset price inflation that puts markets into overvalued territory for significant periods of time, placing volatility risk and interest rate risk into greater territory. One only has to look at the monetary easing love chart to see this volatility in the stock markets when the Fed signaled tapering its asset purchases (2013), or actually started tightening (2016 with the FFR and again in 2018 with the balance sheet). The markets and rates become volatile when the Fed does not provide a continuous backstop. 





The Fed’s “mandate” is low employment and price stability, but it has obviously become primarily a put option on the stock and bond markets, a subset of the economy. These interventions are far from the original “Lender of Last Resort” function envisioned in 1913, though the Fed has for a long while been active in hedging interventions in the Treasury markets to maintain stability there. The resultant asset price inflation of Fed intervention has many economic consequences covered up by inaccurately reported economic metrics. 

The stock markets are supposedly at a level that reflects strong corporate profit growth, but the data suggests that corporate profits plateaued in 2015 yet the S&P 500 has continued to increase substantially. Financial engineering and Fed easing have propelled equity and corporate bond markets to new highs. 




Recently bond king Jeff Gundlach and economist David Rosenberg gave excellent interviews [4,5] touching upon some of the issues I discuss in this article. I leave the reader with final charts and a set of quotes from Gundlach and Rosenberg. 

Happy New Decade 2020-2029. 

                 ~~~~ * ~~~~






Quotes from Gundlach:

“Powell [Fed chair] said in late October [2019] that they’d have to see a significant rise in inflation that is persistent to even consider raising interest rates to fight inflation…so the Fed wants inflation to be higher, and they’ve contextualized this by saying 2% was our target for many years and we fell short, so now we need to “fill the gap” which makes no sense to me. I think it’s cover for wanting interest rates to be below the inflation rate, which seems to be the game plan for central banks in developed countries around the world, so now we have the 10 year Treasury yield below the inflation rate, the CPI is up at 2%, the core CPI higher than 2% and interest rates are kept below that. The Fed knows that we have a debt problem in the United States and to push out the day of reckoning into the future is to have interest rates below the inflation rate. Negative interest rates in the U.S. would really be a problem for the global financial markets. In the next recession, left alone to market forces, long-term interest rates would probably rise. Powell has told us that he will control long term interest rates to fight the next recession through quantitative easing.”

“The overnight Repo market had been struggling to stay in line with the Fed Funds Rate, until it blew out on September 17 [16]…That suggests that the market doesn’t ratify the Fed Funds Rate. The Fed has the FFR at a level that isn’t clearing the market in a free market way for overnight money…they are adding reserves to try to counteract that.”

“In the next recession the amount of bonds that would be issued at the long end would be so horrifically high that I think interest rates in a normal free market clearing mechanism would rise, and they’d rise fairly significantly, and that’s what the Repo market is kind of telling us. On September 17, overnight money was over 2% and the 10-year Treasury was below 2%. It is really telling that you can’t find buyers for overnight money in excess of 2% and yet the 10-year Treasury is below 2% with inflation at or above 2%. That tells you that the interest rate levels being maintained by the Fed are really not market levels, they are manipulated levels. The national debt is growing at over 6% of the economy, $1.27T is the growth in nominal dollars of the national debt which is greater than the growth in the economy.”

“Credit risk is very dangerous. Time to be exiting the corporate bond market is presently…it is enormously bigger than it was prior to the global financial crisis $5T vs. $11T…it is misrated…39% of the corporate bond market should be rated junk…net debt to EBITDA is at all-time record highs…spreads are very narrow by historical standards…foreign buyers are driving up this market chasing yield, not hedging their bets in USD terms…the USD Index should be falling…the USD has held up due to this naked buying…waves of selling in this market will put serious pressure on the USD and tremendous losses in the corporate bond market.” 

“One of the reasons the stock market has gone up substantially is that when you cut taxes you turbocharge the bottom line, profits go up.”

“Foreign currency investments should top USD investments.”

“JPY (1980-89)…EUR (1990-99)…EM (2000-2009)…USD (2010-2019)…my view is that pattern will repeat…the USD will be weaker because of exploding deficits.”

“MBS are relatively cheap compared to Corp Debt…Mortgages have lagged due to prepayment rates…Much more concerned about the over-indebtedness in the Corp Bond markets.”

Quotes from Rosenberg:

“That liquidity injection that’s ongoing, that’s actually QE4, has caused the money supply numbers to go gangbusters, at a time when business credit is actually contracting…that excess liquidity hasn’t found its way into the real economy, it has found its way into risk assets…in the last three months we’ve had this run-up in risk assets that’s had nothing at all to do with the fundamentals despite what the gurus are telling you.”

“This is the weakest corporate spending cycle of all time in the context of the strongest corporate bond issuance…so where has the money gone? Two words: Financial Engineering, stock buybacks, and that explains why the EPS have been inflated, and that’s why we’ve had this very ongoing bull market in equity, in the context of the weakest economic recovery of all time.”

“We’re about to have back-to-back quarters of negative productivity growth in the U.S. so I’m looking for the employment numbers to soften up [in Q1 2020].”

“The U.S. Household Debt/Income Ratio is the highest it has ever been since 2007.”


REFERENCES

[2] “The Fed’s Inflation Target: Why 2 Percent?” January 2019, https://www.stlouisfed.org/open-vault/2019/january/fed-inflation-target-2-percent
[4] CNBC’s Full Interview with DoubleLine Capital CEO Jeff Gundlach, https://www.cnbc.com/video/2019/12/11/watch-cnbcs-full-interview-with-jeffrey-gundlach.html
[5] CNBC and Bloomberg interviews with David Rosenberg, December 2019. Bloomberg: https://www.youtube.com/watch?v=u5aIvU_bmrs.


Inflation, Unemployment, GDP and USD Index Statistics: What can we really believe?

In the next article, “QE4, Repo, Inflation, Debt”, I argue that key measures for inflation, unemployment, GDP and the US Dollar (USD) Index that the government reports and the Federal Reserve (Fed) closely watches are either understated (inflation, unemployment) or overstated (GDP, USD Index), and by a significant amount. Here I discuss in detail the alternate measures that are reported by “Shadow Government Statistics” (SGS), a long-time reputable source for alternate government statistics. I also provide some additional data reported by the U.S. government in each category. 

INFLATION

SGS has an alternate inflation measure that runs some 4% above the currently reported official CPI, and almost 4.5% above the Fed’s tracked core PCE for inflation targeting. The SGS measure diverged from the official government measure in 1983 when the Labor Dept. changed its methodology of reporting, and since 1990 substantially. Basically, the official CPI no longer measures the cost of maintaining a constant standard of living or full inflation for out-of-pocket expenditures. SGS has written a succinct account of these methodology changes and differences [1]. The bottom line is that wage inflation has been far outpaced by real inflation for costs of living and out-of-pocket expenditures. 

It doesn’t take much to look for significant inflation for critical cost of living expenditures, in particular the rise in rents. Housing prices have also risen substantially, forcing those who cannot buy and finance a home to rent, even though mortgage rates are at a secular low. A major contributor to these sharp housing price/cost increases over the last decade arise from sharply rising construction costs. Refer to the attached compiled chart from FRED showing the Case-Shiller Index vs. the official reported CPI for Rents, and the PPI for Construction for new residential homes and building materials from the BLS. The recent high numbers for YoY increases in building costs and new residential home construction are ~8% and 6% respectively. These numbers are probably understated, looking at the reported PPI index value growth over the decade. Even in my local area planners are quoting a whopping 70% increase in building costs over the same period, a real problem for localities with a short supply of rental properties, driving up rental costs substantially and making it difficult for builders to commit to building low income housing. The PCE for Healthcare and Durable Goods reported by BEA has increased to nearly a 5% annual rate, and that is likely understated. 

Given a more realistic inflation rate of 5.7% the Fed should surely be raising its Fed Funds Rate, right? Probably, but with rapidly increasing debt it has chosen not to, using a faux core PCE of 1.6% as its inflation target and stating that inflation is not an issue. 

Cost transparency is critical to gauging price stability. Sharply rising building costs and rising healthcare costs do have supply/demand contributors beyond monetary inflation, but the supply of cheap money has substantially driven up asset prices in certain speculative categories, namely real estate and healthcare. Separating the other contributors out from monetary inflation/risk asset price inflation is difficult but I argue it must be done and all of these cost factors addressed in a transparent set of inflation and cost metrics. Only then can real pressure be put on the Fed and government policy makers for a change. 










UNEMPLOYMENT

The SGS alternate unemployment numbers are probably the most alarmingly divergent metrics from official government reported statistics: 21.5% vs. 3.5% for U3 and 7.5% for U6. Once again, the SGS measure diverged from the government measure when the Labor department changed its methodology by dropping long-term discouraged workers from the U6 measure in 1994, and apparently there are many long-term discouraged workers out there that are unemployed (at least 14%). Where did they go and how do they subsist? Those that can not subsist on savings or the income of a family member are on public assistance or disability. The structural problems in the labor market that contribute to the number of long-term discouraged workers have only become more pernicious. They relate to the drops in productivity, industrial production, manufacturing, and an increasingly negative balance of trade (current balance). Skills gaps are certainly an issue, one business leaders complain about but do little to solve for this group, and any other employment group that might be productively employed in a skilled job. 

So why have long-term discouraged workers been “defined out of existence” as SGS succinctly puts it? Answer: It is politically expedient for both politicians and business leaders. Training costs money that hits the business bottom line and profits, and politicians gain from increasing welfare rolls. The long-term cost to our economy of this ignorance is much higher public debt and a waste of human resources, not to mention an unethical disregard for telling the truth about the real employment situation while taking a stage bow and victory lap for a ridiculous 3.5% number. It will only get worse unless the structural issues are fixed. 








GDP

The SGS alternate real GDP is some 4% below the Bureau of Economic Analysis (BEA) reported official real GDP in YoY terms watched by the Fed. The difference stems from adjusting the reported nominal GDP with an alternate measure of inflation that better reflects cost increases that were removed from inflation measures in the 1980s and 1990s, in particular from the PCE deflator, a woefully understated metric reported by the BEA, and used to calculate the reported real GDP. Additionally, the methodology for calculating the GDP was intentionally changed by the Commerce Department/BEA in March-July 2013 that “expanded” the reported gross investment (I) of the GDP (GDP=C+I+G+(X-M)), resulting in an increase to GDP of some 2.5-3%+ ($500B in 2017). Added to gross investment were R&D spending, and royalties/spending for film, music, books, art and theatre (from the BEA [3]: “Private fixed investment in R&D, entertainment, literary, and artistic originals”). Additional changes were made to the GDP calculation methodology in mid-2015 and in 2018 [4], primarily seasonal adjustments for defense spending that smooth out GDP from showing negative growth in certain quarters. 

Basically, between an understated PCE deflator, overstated additions to private fixed investment, and smoothing tricks for defense spending, we now have a reported headline real GDP that avoids any official indication of a recession. How is that useful? It’s politically motivated and it helps policy makers avoid addressing tough systemic problems. It probably also avoids scaring equity and bond markets into difficult volatility. 

Despite these numerous changes over the last 7 years, plus historic easing by the Fed and a marked rise in government spending, we still have rather anemic reported real GDP, <=2%. In reality, looking at the unmodified SGS GDP, we have been in recession for nearly 16 years. 






US DOLLAR INDEX

A strong US dollar is important for purchasing power and reserve currency status. The market US Dollar index DXY and the broader government reported trade-weighted US dollar index have been hovering around a local high since early 2015, likely in anticipation of better economic conditions in the US and a relative reduction of Fed easing. Reception of a strong dollar is mixed – US buyers purchasing imported items generally favor a strong dollar, but sellers (exporters) and multinational corporations generally benefit from a weaker dollar, or they must hedge the dollar in some way. “Beggar thy Neighbor” is an old term used to describe the international race of currencies to the bottom, through currency weakening tactics. Recently, the Fed has not intervened in an overtly major way to influence the dollar, as other central banks have done for their respective currencies. This may change as trade conditions and deals evolve between government “brokers” – the US government executive brokers are already clamoring for a weaker dollar to compete with other major trading partners that have an overtly active hand in weakening their currencies. In the past at various points, intervention to weaken the dollar has happened – serious dips in the U.S. dollar index reflect some amount of intervention contributing to the weakening, primarily of a monetary easing nature. 

The US dollar index DXY is a market index measure of the value of the US dollar relative to a basket of foreign currencies, and is maintained and published by the Intercontinental Exchange (ICE). The data series extends back to March 1973, where it was defined at Index=100, but with backdating to January 1971 (before Bretton Woods!). This index has been a stable measure of the US dollar value relative to the Yen, GBP, Canadian dollar, Swedish krona, Swiss franc and other European currencies that got rolled into the Euro in 1999, the only time this series has been altered. The index measure clearly shows periods of sustained weakness in the US dollar that resulted from monetary easing intervention. 

An alternate measure that is reported by the Federal Reserve Board (FRB)/FRED is the trade-weighted US dollar index, “a weighted average of the foreign exchange value of the US dollar against the currencies of a broad group of major U.S. trading partners. Broad currency index includes the Euro Area, Canada, Japan, Mexico, China, United Kingdom, Taiwan, Korea, Singapore, Hong Kong, Malaysia, Brazil, Switzerland, Thailand, Philippines, Australia, Indonesia, India, Israel, Saudi Arabia, Russia, Sweden, Argentina, Venezuela, Chile and Colombia… Series is price adjusted.” Wikipedia defines this index as “a trade weighted index that improves on the older U.S. Dollar Index by using more currencies and the updating the weights yearly (rather than never). The base index value is 100 in Jan 1997.” I attach a comparison chart of the historic US dollar DXY with the revised FRB trade-weighted US dollar index in the attached graph, with my annotations. I hold back no punches. The FRB attempted to show that the USD index was stronger than the historic DXY, but both show systemic problems with currency manipulation, fiscal instability and economic weakness. 

Another alternate measure of the US dollar index is calculated by SGS as the Financial-weighted dollar index, defined as “a composite value of the foreign-exchange-weighted U.S. dollar, weighted by the proportionate trading volume of the USD versus the six highest volume currencies: EUR, JPY, GBP, CHF, AUD, CAD.” SGS publishes a comparison between the FRB trade-weighted US dollar index and its own SGS Financial-weighted US dollar index, and it shows a 7-10 point difference that indicates that the FRB index is understated as the so-much-better broader index defined in the 1990s to fix the original unaltered DXY series. SGS indicates that this difference stems from the FRB application of the “USD weighted by respective merchandise trade volume against the same currencies.” 







REFERENCES

[1] “Public Comment on Inflation Measurement and the Chained CPI,” April 2013, http://www.shadowstats.com/article/no-438-public-comment-on-inflation-measurement.
[2] “Public Comment on Unemployment”, June 2016, http://www.shadowstats.com/article/c810x.pdf.
[3] “Gross Domestic Product and Gross Domestic Income Revisions and Source Data,” https://apps.bea.gov/scb/pdf/2014/06%20June/0614_gross_domestic_product_and_gross_domestic_income.pdf; and “The Revisions to GDP, GDI, and Their Major Components,” https://apps.bea.gov/scb/pdf/2014/08%20August/0814_revisions_to_gdp_gdi_and_their_major_components.pdf
[4] “Updated Summary of NIPA Methodologies,” https://apps.bea.gov/scb/2018/11-november/1118-nipa-methodologies.htm


Global Debt Watch: $126.5 Trillion and Counting

Last time I tallied the global outstanding debt was in 2011 using 2010 data. At that point, the number stood at $95.5T. 

I recently updated this tally using mid-2019 data from the Bank of International Settlements (BIS), and the latest number stands at $126.5T, a 32%+ increase. U.S. debt outstanding is over 3x ($42.2T) the next highest debtor, now China, who surpassed Japan in the last two years. This follows significant growth in issuance of U.S. Treasury debt (funding an all-time high in the Federal public debt) and Corporate debt (fueling record levels in the corporate bond market), but also brisk growth in Mortgage and Household debt. China is dealing with its own issue of high debt levels amidst a slowing economy, and the Eurozone is struggling with wildly unpopular negative rates that do little to spur weak economies. 





In the next two articles I discuss the impact of this growing debt and the typical central bank response of greater easing, with a rather reckless disregard for the actual statistics that point to a 16+ year ongoing recession in the U.S. alone. 

“The US Federal debt is not like other debt” is an often-heard quote from those asked what the impact will be from growing U.S. public debt. Like ongoing Fed easing, growing debt has a serious consequence only to be revealed. 

I leave the reader with a set of charts that I prepared from the Federal Reserve Economic Data (FRED) database that specifically show various components of the growth in U.S. debt outstanding over the last several decades, and the trend in interest rates. 







Wednesday, May 22, 2013

Money, Credit and Collateral: Why Quality and Value Matter

The debate over liquidity deconstructed: creation of quality collateral is not sustainably possible via asset inflation schemes. Value and valuation cannot be consistently gamed and subverted.

A primary systemic risk in the 2007-8 financial crisis was relatively poor collateral underlying highly leveraged instruments. When interest rates rose due to Fed tightening after a sustained period of artificially low rates, those instruments became distressed once a negative equity condition was reached, and perhaps even prior to that condition, based on market anticipation. Duration mismatch for spread bets (borrowing short and lending long) was also an oversubscribed game, adding significant systemic risk. The evidence of these dynamics can be found in the growth of the collateralized debt obligation (CDO) and the repurchase agreement (repo) markets, among other related structured finance, debt and funding/financing markets, including mortgage backed securities (MBS), commercial paper, auction rate securities, etc. - this growth was geometric with a pronounced flare toward the 2007-8 crashes. The growth in these markets coincided with significant inflation in housing and commercial real estate, among other asset classes, and can be characterized as part of the "liquidity" bubble that fueled the asset price inflation, leading to unstable financial conditions, namely a catastrophic failure of structured financial instruments backed by inflated assets that ultimately provided the fuel to ignite other systemically wide failures. In short, parts of the financial system went from highly liquid to illiquid. The same trend occurred in Europe post-2008: from 2008-11 there was a pronounced growth in their CDO and repo markets, and inflation of similar asset classes, as well as sovereign debt. I have covered the data on these clear historical events in prior posts here, located below.

Post crises, the CDO, commercial paper, ARS,..etc. and repo markets were drained substantially and today they are reportedly nowhere near their peaks. What has not abated: the continued issuance of sovereign debt and MBS, setting records [1] in debt outstanding. Corporate debt issuance, both investment grade and high yield, are at record highs [2].

There is a prevailing school of thought that the Fed and other central banks must pump up this liquidity once again, in the case of the Fed by buying Treasurys and MBS (quantitative easing, or QE), and by leading the drive to a zero-bound interest rate environment (ZIRP). This has led to a record growth in the adjusted monetary base (AMB). As I pointed out HERE earlier in the year, this has not yet led to a growth in the velocity of money (VoM) as measured, but it most certainly has and is leading to asset price inflation across many asset classes, namely the U.S. equity and debt markets, which are sharply pegging new highs as I write this missive. In point of fact, all debt markets and related equity proxies are enjoying record price inflation as a result of Fed interventions, investor scrambling for yield/returns in a record low rate environment, and trend trading/chasing by market participants. Indeed, the pendulum has swung in the other direction, and there is even talk of pushing real interest rates further negative.

What has given the Fed license in part is the claim that broad inflation is low. However, traditional quantity theory of money (QTM) measures are not providing a useful tool for gauging inflation, particularly asset price inflation, and more to the point, the various funnels of hot money flow as a result of Fed policies and the reaction of market participants to its endogenous lead. QTM monetary measures do not accurately capture newly created monetary equivalents or credit money, or hot money flows. The Fed stopped reporting M3, which tracked repo and Eurodollar flows in 2006, and it has not been replaced by an improved metric. Liquidity as measured by new money equivalents, credit money and hot money flows that lead to asset price inflation are not part of any tracked metric. The AMB and excess bank reserves do not clarify the entire picture, and snippets such as margin debt have limited use, though these measures are again at the peak levels seen in 2000 and 2007. The view of some is that we remain in a "liquidity trap," that there is a dearth of borrowing and a propensity toward deflation. The reality is that we are coming off a significant era of inflation through disinflationary deleveraging, with a Fed providing a growing liquidity floor that has led to those funnels of hot money flow, record debt issuance by corporations and the sovereign, and asset price inflation. By inflating assets, collateralized debt and derivative instruments and collateralized funding markets become unstable if those instruments and markets are backed by inflated assets - enhanced by risks such as interest rate (duration) risk, among other risk factors. No amount of gaming or subversion of value and valuation of those assets will change this outcome. This is not sustainable, and nor is the issuance of "quality" debt at record low and lower rates. Broad real economic growth has been stagnant in the era of driven ZIRP, with asset price inflation providing a cheap high that has further systemic costs.

The point I want to leave the reader with is that the Fed and economic participants cannot create quality collateral via inflation of assets. Yet they keep trying to play this game, over and over. QED


[1] Data on issuance and outstanding levels of sovereign debt can handily be found at SIFMA for U.S. Treasurys and the BIS for ex-U.S. sovereigns. Data on issuance and outstanding levels of U.S. and Eurozone MBS and other structured debt instruments can also be found at the SIFMA link.

[2] Data on issuance of U.S. and ex-US corporate debt can be found at the SIFMA and BIS links above. The strong upward trends to net issuance and amounts outstanding are quite clear from 2010-12, with 2013 likely setting new records.

 

 

 

Saturday, May 4, 2013

A Black Swan in the Interest Rate Markets

A sharp, uncontrolled rise or discontinuity in interest rates can have systemically wide risk costs.

Stay Tuned...

Thursday, January 31, 2013

Why Investors Need New Markets

Can investors trust the financial markets, notably the public equity, options, futures and debt/credit markets? The short answer is: No. Why? Here are just a few salient reasons, in no particular order:

  • Rumors for Profit. With daily rumors running amok in the financial media and elsewhere, many investors are left vulnerable by this mill, controlled by those who have the power and perch to create and disseminate false or misleading information, and a conflict of interest, in that they can profit from the trade.
  • Government Intervention. With the Federal Reserve buying $1Trillion+ of Treasury and Agency/MBS debt in 2013, not to mention an open-ended mandate to increase that figure or buy up other outstanding debt, markets are manipulated, become dependent, and do not adequately factor risks from such dependencies. Moral hazard has taught the Main Street investor that those who take inordinate risks from the flow of cheap money at the top and lose will be bailed out, at Main Street’s expense. With U.S. net leverage at a 6-yr high, these inordinate risks are a red flag.
  • Dishonest Money/Asset Management. The Main Street investor is repeatedly told to put money into the public markets, even at cyclical/secular tops, on the pretense that not to do so will result in a lost opportunity. The latest cheerleading comes from such Wall Street investment banking and asset management characters as Lloyd Blankfein of Goldman Sachs and Larry Fink of Blackrock, two recipients of the bailouts in 2008/9.
  • Understated Counterparty Risks. In public financial markets, investors are exposed to counterparty risks whether they want that exposure or not. These risks range from undercapitalized market makers to highly leveraged speculation to overdependence of Ponzi Finance. Counterparty risks such as these were largely responsible for the failures in the financial system in the 2008 credit/housing market crises (for excellent references, see HERE, HERE and HERE). Underpriced risk on credit/debt instruments due to misstated ratings by market sanctioned rating agencies was, and still is, a factor.
  • Inefficient Price Discovery. When there is less transparency in a market, prices will not have absorbed hidden or less known information and become more unpredictable. Transparency includes knowing who is on the bid/offer and who makes the buy/sell. Less liquid markets will also show wide price spreads, as the market makers seek to pad the uncertainty in those markets with risk premiums. In the worst cases, prices do not adjust to reflect information that has become known to the market: this can happen in the options market, where pricing of the option becomes decoupled from the pricing of the underlying instrument.
  • Manipulative Trading. Not all speculative trading is manipulative, and there are positives in markets from the presence and participation of speculative traders, especially if they enable liquidity. However, manipulation can occur from insider trading, as well as large block trading meant to corner markets, affecting price discovery. Eliminating market corners has been as effective as eliminating insider trading. Banning speculative trading has clear negatives for existing electronic financial markets, yet some investors would rather not be in a market with such counterparties and activity, regardless of the positives or negatives, as they (correctly) perceive this activity as gambling in a casino. I will state that I believe that the casino nature of our traded financial markets has existed for well over a century, so this is nothing new.

So how can investors looking for a place to put cash/capital to work avoid these perceived market negatives? My answer: we need new markets. Innovation in new markets and investment opportunities will go a long way toward fending off the negatives that “entrenched” markets have come to acquire. Some will say that new markets will just become entrenched too, so why bother. This defeatist attitude did not hinder those in the past who pushed ahead in the face of adversities to realize new markets that go on to thrive and grow competitively. Here are just a few short ideas, all consistent with the concept of “free markets:”

  • Markets that create disincentives for moral hazard, where failures drive out bad counterparties.
  • Markets that work around the SEC “Accredited Investor” rule, which shuts out many Main Street investors on lucrative return on investment (ROI) opportunities, all in the name of “consumer protection.”
  • Markets that incentivize longer-term investments [most venture capital and private equity investors are relatively long-term, and as “insiders” can obtain higher potential ROIs].
  • Markets that build in fault tolerances that are not a result of over-regulation but of design/construction consistent with free markets.
  • Markets that spread out risks [note we have to be careful that this does not lead to moral hazard: that the large risk taken by one actor is not borne by all the others, but is proportionally absorbed by that actor].
  • Markets that maximize transparency and disclosure of information, and that optimize price discovery.

Critics may reiterate that any new markets will adopt the same market factors as I listed at the top, making it difficult to realize significantly different outcomes. Some critics may state that what I call negative entrenchments are fundamental to any market, and that investors need to learn how to cope with them, investing their money in the available choices and environments. Nonsense. Once again, if we don’t try to innovate and create, and instead adapt to entrenchment, then sure, investors will be served with the same range of outcomes. Limiting choices is what causes entrenched negatives, and only by increasing choices and competition can investors realize a broader range of outcomes, and enable investing in markets that more closely align with investor “value systems:” in short, become value propositions that cause money to shift from one market (the old) to another (the new). Absent new markets and more competition, we face further market entrenchment and stagnation, and even failures from instabilities, such as increased investor disenfranchisement and alienation. It is not impossible to imagine a run on markets that become too hostile to investors. Yet the establishment (read: the mainstream financial media, money/asset management, government regulators) will consistently claim, as they do now, that investors need to get with the program and put their money into existing financial markets, for they have few other choices to earn yield on their money. As I have written previously, this form of financial repression and coercion will backfire, as it always has, historically. Only by increasing choices in markets, and freer choices at that, providing genuine value propositions, can investors demanding trust and other value factors be invigorated. The monopoly to oligopoly financial world we live in is not a fait accompli.


Readers should note that a basic definition for a market is one where participants disagree on value, but agree on price. If investors are limited by what they perceive as value, and refuse to participate in those limited choices, then existing markets may deteriorate unless they have enough participants willing to engage in this basic process. Disappointed participants will simply walk away and hoard cash, or go to any market (even underground markets) that will serve them the process they are looking for: exchange of value at an agreed price. Financial repression and coercion via entrenched market interventions and manipulation are destabilizers. Investors have come to expect and demand more, or they should.


My suggestions for new markets contain many generalities, and need to be focused to allow for specific implementation, particularly in an environment of increasing central planning and regulation. These challenges can be overcome, and I intend on addressing these issues in future articles. I invite readers to add to the suggestions, and to provide specifics on implementation, or simply to provide links to efforts out there that look like they have a chance of success. Only by sharing and proliferating ideas can we start to see a renaissance in our markets.

Saturday, December 29, 2012

The Damage Caused By the Fed's Zero Interest Rate Policy (ZIRP)

Accounting for various inflation measures, the target and daily effective Fed Funds interest rate has been negative since 2009. The Fed has reiterated this so-called "zero interest rate policy" or ZIRP, indefinitely, and additionally has tied further monetary easing measures via bond and asset purchases not only to inflation, but to unemployment, regardless of the lack of evidence that such monetary measures positively affect growth leading to less unemployment. Rates on Treasury Inflation Protected Securities (TIPS) recently hit a record low yield to maturity of -1.496% on 4-year, 4-month issues, forcing the obvious question: Who would buy these things? Evidently, investors are willing to accept getting paid back less than the principal loan at maturity on the expectation that regular payments tied to the government's understated consumer price index (CPI) inflation measure will make up for the negative yield to maturity over the life of the loan - the auction was relatively strong, with a 2.7 bid-to-cover. The likely outcome is that investors will barely break even or lose money, given that inflation and risk will be running higher than expected or as sold to investors.

Creditors and savers lose money in this ZIRP environment, while debtors gain. That has been the goal of the Fed all along, to manipulate the cost of money so as to provide a bailout to all of those debtors, deleveraging or not. The accepted term for this ruse is appropriate: Financial Repression. What the Fed does not admit to is that this practice has significantly skewed the risk-reward for investors willing to lend money, and has created systemic risks tied to the interest rate markets. Both of these side effects have an impact on private investment, and by extension, real economic growth. On a basic level, investors willing to lend money want to see the level of risk tied to the potential reward, as set by market pricing, not as manipulated by a cartel. If that reward has a manipulated ceiling, or has a higher than expected probability of losses (negative reward) due to interest rate dislocations, defaults or other risks not priced in, then investors will shy away from taking any risk at all: they simply will hoard their capital and not lend. We've seen strong evidence of that in the last 3-4 years, as a result of an accommodative Fed feeding overextended debtors looking for a cushy reprieve from the housing and credit market bubbles the Fed helped to create.

Much talk has been made recently about how and when the Fed will proceed to raise interest rates and unwind its growing balance sheet of Treasury and Agency (MBS) securities, bought to keep interest rates artificially low for government borrowing, public mortgage financing and debtor refinancing. Existentially, there is a threat that interest rates could rise without a Fed change in ZIRP: the interest rate markets could dislocate rates higher to more accurately reflect risks. The danger is that dislocation could be severe and lead to significant losses in bonds and in interest rate sensitive securities and derivatives, including currencies. It has been my conviction that the Fed has not quantified this "Black Swan" event or series of events. The severity is potentially very high given the collaterized nature of Treasury and Agency securities within the global financial system, including the repurchase agreement (repo) markets. Rated securities used as accepted collateral experiencing significant sharp losses will have a systemic effect across the system. Critics answer this existential threat by stating that the Fed could simply flood the system with liquidity (printed money), in the magnitude and durations needed to restore stability. This is a fallacy; as I have pointed out in other essays, the Fed is an endogenous (not exogenous) entity, not unlike a large hedge fund, and the belief that it could perpetually print money to save its "system" is as wrong-headed as believing in perpetual motion machines. Trust is not infinite, and Federal Reserve Notes and Treasurys carry risks tied to trust.

Creditors and savers (investors) held hostage by the financial repression of ZIRP have little wiggle room other than to continue to push for changes in the powers carried by the Federal Reserve. Those powers are sold to all of us as a common good, when in fact it has led to an involuntary wealth redistribution scheme, a tax meant to benefit government and politically recruited debtors, with a leveler outcome of stagnant or negative real growth. At its worst, these powers have throttled systemic risks and will continue to do so, instead of unshackling markets and investors to allow for markets to set price levels and risk-reward curves based on supply and demand, and not on politically-motivated cartel manipulations.